Fellow Partners,
We now have one month under our belt. I have shifted the partner updates and associated resources to Substack, which means this information is now sent to your inboxes and hosted here for on-demand access.
As always I welcome your candid, direct feedback.
Here is the September update.
Summary
Welcome to two new partners — Andrew and Brian!
Major components of the economy that we experience — restaurants, airlines, hotels — have minimal impact on market performance.
The US economy did not shrink in Q2 2020 by the 32.9% that was reported. The real figure was about 9.5%.
The Fed flooding the market with money, prices being set at the margin, and the popularity of passive investing have created strange, uncommon dynamics in the current market.
We are still buying stocks, being cautious not to overpay, and positioning ourselves in the midst of powerful tail winds.
What is happening
The market is rallying. The economy is tanking. Does this make sense?
This is the most common question and discussion I’ve had in the past month, and I did a fair bit of digging and reflecting before it all “clicked”.
In short, there is a substantial incongruity between how we experience the economy — moving through cities, seeing businesses closed, spending far less on restaurants, planes, hotels, in stores, etc. than normal — and how those businesses contribute to the stock market. “The economy is not the market” is the phrase du jour, though the degree to which this is true is under-appreciated.
A few examples from the S&P 500, the most widely followed proxy for US market performance (all data from late August 2020):
All airline stocks in the S&P 500 — Southwest, Delta, United, American and Alaska — account for just 0.21% of the index. The index’s largest business, Apple, is 33 times larger. So while the airlines are down 46% year to date, they have barely impacted market returns.
Resorts and casinos — Sands, MGM, and Wynn — are just 0.13% of the S&P 500 index.
The only department store still in the S&P 500 — Kohls — is a mere 0.01% of the index.
The story is similar for restaurants, hotels, cruise lines, travel services, and other industries that are very obviously struggling. While we see them often, they are a minuscule component of the overall market.
By contrast the S&P 500’s five largest members — Apple, Microsoft, Amazon, Facebook and Google — are nearly 24% of the entire index. These five firms have contributed 94% of the market return year to date. The big are getting bigger.
What about the economy?
The economy is shrinking. But by how much? A recent notification on my phone read:
U.S. Economy Shrinks at Record 32.9% Pace in Second Quarter [1]
There’s no substitute for first-principles thinking. As I mulled this over it didn’t pass a basic logic test — especially in light of the market composition discussion above. Did the U.S. economy really shrink by 1/3 in three months?
No. Not even close.
That 32.9% figure is the percentage by which 1Q 2021 GDP would be below 1Q 2020 GDP if GDP were to decline in the next three quarters at the same rate as it did in 2Q 2020 [2].
If that seems like a useless number — it is.
Reality check: no one expects this to happen (e.g. Morgan Stanley currently expects full-year GDP to be down c. 5.3% year-over-year).
A clearer perspective would be to ask: how much did Q2 2020 GDP shrink vs. Q2 2019 GDP? The answer: 9.5% (real GDP) or 9.1% (nominal GDP).
Not great — but nowhere close to the 32.9% that news outlets had a field day with.
Strange, uncommon dynamics
Did Apple really double in value in 2020?
No.
In the past five years Apple’s revenue growth has slowed to a crawl and margins have declined. Free cash flow — the life blood of any business — is flat.
But some powerful forces have combined to more than double Apple’s stock price (and many others) since the US market bottomed on March 23rd this year.
First, the US Federal Reserve has flooded the market with money at a speed and scale unseen in US history. Recipients seek to put this money to productive use.
Second, stocks are priced by the most recent transaction between a buyer and seller (prices are set at the margin). A minority of exuberant traders can take prices into silly territory.
Third, more than half of stock investments are via passive vehicles which trade according to their formula. For example, $7 out of every $100 put into an S&P 500 index fund is invested in Apple since it is so large. And the higher the price of Apple stock rises (relative to other S&P 500 index components), the more the indexes must buy. It is a flywheel that can go on for some time.
Finally, our short- to mid-term reality has shifted in light of the Fed’s extreme commitment to keep capital markets flush with cash. The Fed moved the price of money (the interest rate) close to 0%., which drove down government bond yields, which led investors to accept lower prospective returns for stocks.
Historically investors have demanded about a 3-5% premium to hold stocks over government bonds. A 4% yield is equivalent to a price/earnings ratio of 25, which is about where the S&P 500 is now. This is a level not seen since the early 2000’s, but to be expected in an environment with such low interest rates.
Should we sell?
If we bought well, no. Here’s a gem from Peter Lynch that I often return to (2 minute clip):
So what are we doing about all this?
We are buying stocks, with our philosophy of buying wonderful businesses at fair prices. This environment turns up the volume on both of those factors.
There are many wonderful businesses in the today’s market that we would love to own, but are just too rich at these price points. “Priced for perfection” is a good line. Basic reasoning tells us that these firms must get everything right — for years and years into the future — to justify their current prices. Buying at these prices would create substantial risk to our ability to compound capital even if the businesses remain wonderful. Hoping for even-greater enthusiasts to come along and pay even-higher prices is not investing.
By the same logic, quality is always important, but especially so in this market which is and will continue to weed out poor businesses and poor business models. Off balance sheet leverage (high fixed cost) has rightly been discussed in huge volumes over the past few months, as has its opposite (zero marginal cost).
The forces outlined above will continue to play out in the short- to medium term. This makes positioning within strong tailwinds critical. We want to benefit from the Fed fund induced flywheel and associated market re-valuations, without risking our ability to compound capital over the very long-term. Our ability to be patient and play the long-game is critical and a major strategic advantage.
Bezos is one of the best in this philosophy. When he was congratulated in 2017 on closing a strong quarter, this was his response (1 minute clip):
Combining patience and playing the long game with powerful tail winds is another major strategic advantage.
The emergence of and shift to SaaS (Software as a Service) is one such tail wind. The shift is happening en masse. SaaS poster child Salesforce.com grew to overtake on-premise software poster child Oracle in late July 2020.
But for all the headlines, SaaS software is still tiny. SaaS revenue only crossed $100Bn in late 2018. That’s 0.01% of the $85Tn global economy, and a business model in which marginal cost is zero. (Side bar: It is ironic that I studied at the London School of Economics, then joined a SaaS firm in which the economics I was taught were useless. Academics still need to adapt their theories to zero marginal cost business models.)
Combine this with the fact that Enterprise SaaS adoption is still relatively low — about 20%. This could easily expand to 60-80% as cost, speed, and services are generally superior in SaaS (vs. Non-SaaS) engagements. ARK recently published a nice succinct piece of research on the trend (see graphic below, from the same piece). [3]
There is much more to come in future Partner Updates on these dynamics and how we are executing on them.
Updates and reminders
We can now invest IRA assets. Please reach out if you would like to discuss.
Join our ongoing discussion and debate in our Slack community. Use this link to join.
A web portal for on-demand statements will be launched in the coming weeks.
If you know potential partners who would benefit this community and who share our long-term, patient, focused values, please connect us.
All the best,
John
Founder and Managing Partner
Notes and references
[1] https://finance.yahoo.com/news/u-economy-shrinks-record-32-123047521.html
[2] https://www.oaktreecapital.com/docs/default-source/memos/timeforthinking.pdf
[3] https://ark-invest.com/white-papers/saas-white-paper/